How do you top a note that goes into the unlikely but vivid possibility of serious social unrest, civil war and authoritarian governments in modern Europe?
Such a conundrum faced UBS Europe economists after their warnings earlier this month of what a eurozone break-up could mean a few weeks ago. In a new note, they say things have entered a more dangerous phase now. A €1,000bn – €2,000bn levered rescue fund appears unrealistic, they say, amid the opposition to the ECB funding the EFSF.
The UBS team believe a Greek default is inevitable, and the only questions are how soon it will happen, and how well it will be managed. Their base case is that a default – much less exit – will be avoided in the short term, as the Troika reach agreement with the Greek government on the next round of funds, and a debt swap involving the private sector goes ahead even if participation does not reach the desired 90 per cent level. These outcomes considered, UBS economists put the probability of a Greek default in the next few weeks at 10 – 20 per cent. A default by early 2012 however is put at 50 – 70 per cent, if Greece is ringfenced adequately with measures including an expanded EFSF and capital buffers for banks.
However, even the base case looks bad, they add. In the case of a delayed and orderly default:
We underscore, however, that any relief rally would be temporary and shallow. The root issues of sovereign default, bank recapitalization and the absence of growth would remain unaddressed, suggesting only limited recovery prospects for markets.
The preceding discussion suggests that it will most probably will take an intensification of the crisis and the realization that disorderly default could lead to severe economic dislocations in the creditor countries in order to mobilize political support for government-funded bank recapitalization in Europe. In that sense, the outlook for risk assets, above all for equity markets, remains challenging over anything but the tactical horizon, even in the ‘base case’ of no disorderly default or exit.
So much for the base case. Here are their Risk case scenarios (emphasis ours throughout):
Risk case 1: Disorderly default
It may be, however, that compromise between the ‘troika’ and the Greek government becomes at some point impossible. That could occur if the Greek government (and broader socio-political backdrop) is unable to deliver compliance with the IMF program of fiscal austerity, structural adjustment and privatization. This risk scenario could then unfold with a unilateral Greek default, which if not adequately anticipated and provisioned in the form of capital buffers in the financial sector, would lead to the default and collapse of much of the Greek banking system (given its extensive holdings of Greek government debt), which would then spread via counterparty default to the non-financial corporate and household sector in Greece, as well as to the financial counterparties elsewhere, above all in European banks, pension funds and insurance companies. Plausibly, rising risk premiums would also lead to rising bond yields and widening spreads in the government debt markets elsewhere in the Eurozone, above all in Italy and Spain. Selling pressures could easily overwhelm the modest buying-power of the EFSF (assuming its mandate to buy bonds has been approved) and could even challenge the ability or willingness of the ECB to engage in very large-scale bond purchases. The resulting rise in risk premiums would depress economic activity, quite possibly pushing weakly-growing economies such as Italy’s into recession, exacerbating sovereign credit risk perceptions. Financial stress and heightened uncertainty would almost surely be transmitted globally, dealing another shock to the already-fragile and wobbly US recovery. Indeed, we believe it would not be an overstatement to consider disorderly Eurozone sovereign default as the chief risk to global recovery.
They hark back to the eurozone exit possibility, which their earlier note estimated would be far more expensive than a total bail-out of Greece. But a disorderly default could be almost as bad:
Risk 2: Eurozone exit
In a recent paper “Euro breakup – the Consequences” we demonstrated how complex and costly expensive breaking up the Eurozone would be. The worst case scenario would be the exit of a weak country, such as Greece. Less costly, but still very expensive, would be the case of a strong country leaving the Eurozone. The ‘direct’ costs include sharp increases in risk premiums and large moves in exchange rates, which would likely result in recessions everywhere, compounded by very high inflation in weak countries that exit and issue their own currency. But the costs extend to widespread financial stress and default. Currency mismatches between assets and liabilities could lead to very large private sector defaults. Beyond that, it would be difficult, in our opinion, to contain financial risks, including bank runs in other ‘at risk’ countries. The ensuing dislocations in economic and financial terms could even result in severe social unrest and pressures on the political fabric of the EU itself. Elsewhere we have detailed the potential costs of Eurozone exit, either by a weak or strong country departure. We will not repeat those scenarios or calculations here—the interested reader is referred to the publications at the end of this document. However, suffice it to say, that exit represents in all likelihood the most adverse development of all, with output losses for affected Eurozone countries ranging from 20-40% of GDP (if not higher), accompanied by widespread bankruptcy and financial dislocation. Yet that does not mean that exit can be ruled out. In the scenario of a disorderly sovereign default outlined above, political pressure might well result in exit, particularly if the defaulted government had little prospect of receiving financial assistance from the EU, ECB or IMF. Needless to say, however, the broad market implications of disorderly default and exit only differ by degree. In either case, surging risk premiums and falling output would lead to declines in equity prices, widening credit spreads and financial market dislocations on par with those of the immediate post-Lehman brothers market melt-down. The refuges of risk-averse investors would most likely include the usual suspects: cash, the US dollar, Swiss franc and gold.
And finally, recession risk alone:
Risk 3: Recession
The latest stresses emanating from the Eurozone crisis are arriving at a time when the global economy slowed and is therefore more vulnerable to shocks. As global economist, Andy Cates, recently noted, model results suggest the probability of a global recession have risen to 15% from about nil just a few months ago. Global economic activity indicators have slumped relative to consensus estimates over the past month. And although the weakness is pronounced in sentiment and survey measures, concerns are rising that ‘hard’ activity indicators may turn sharply lower as well. The Eurozone crisis imparts two adverse shocks to the world economy. First, heightened uncertainty erodes confidence, resulting in weaker (discretionary) outlays by households and firms alike. Second, increased financial stress and rising counter-party risk—as evidenced by Eurozone bank funding gaps—threatens to curtail credit to the real economy.
H/T ZeroHedge, which has the full note.
Who is the doomiest of all? FT Alphaville